Where Bond-Fund Skippers Are Sailing

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With many investors scratching their heads about what might be next for the bond market. We decided to take a closer look at where active bond portfolio managers are placing their bets. Joining me to discuss that topic is Eric Jacobson. He is a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Hi, Christine. Great to be with you.

Benz: Eric, you took a look at where intermediate-term bond managers, those who have active strategies, are positioned relative to the benchmark Barclays Aggregate Bond Index, and as you looked across some of these positionings you actually came up with a few themes that you noted. One is a general tendency toward emphasizing credit-sensitive parts of the bond market. Let's drill into that a little more deeply and find out what you found.

Jacobson: Sure. Well, I think if you look at the breakdown of intermediate-term bond funds relative to each other and to the benchmark, what you'll see is this tendency in particular to hold fewer Treasuries and much more in terms of as you say credit-sensitive bonds. I say [credit-sensitive bonds] instead of just saying corporate bonds because all you have in the index are investment-grade corporate bonds, you have a little bit of other stuff, a small allocation to commercial mortgage-backed securities, but you don't have a lot of the other ancillary things that funds sometimes invest in that are outside of that narrow scope, including for example, high-yield bonds, which have found their way into the core bond area, the broader group of taxable-bond funds, specifically intermediate-term bonds.

Benz: So, do you think it's that some of these bond managers are just saying the high-yield is a way to pick up a little bit of extra income and maybe look competitive or are you hearing from fund managers that they actually think the high-yield sector is still attractive?

Jacobson: I think we're not hearing that as often as we were maybe a year ago. Certainly I think there is a recognition that, that spreads are getting tighter. You're starting to hear managers talk about it being more the bond-pickers market than a broad opportunity because spreads are particularly wide. But let's face it, there is also a general need on the part of bond managers to compete with each other based on yield.

So, it's very difficult sometimes to suss out just how much of that is a true and believable assertion that, "Yeah, we think everything looks great and cheap that's why we are buying it." Or "Are we buying it because the money is coming in. We've got to put it at someplace. We want to make sure we keep our yield high enough to attract investors."

I hate to ascribe anything that sinister to fund managers. You don't seem to necessarily find it on a one-by-one basis, but we know in a broader sense that that's kind of how the market sometimes works.

Benz: Another area that you identified that some of these active bond managers have been adding to or had that's certainly not represented in the Barclays Aggregate Bond Index is emerging markets. Let's talk about how widespread that practice is and also, if you have any sense for the motivations for fund managers who might be buying emerging markets right now.

Jacobson: I would say it's widespread enough that it's worth mentioning. It tends to be a little lumpy. I mean you don't find it everywhere in the category, but where you do usually find it is sort of an important thesis. PIMCO Total Return is the flagship. That's the one we often think about and hear about, and it plays such an important role in the category as a trend-setter. And the fact of the matter there is PIMCO has been arguing for long time that the best growth prospects and the healthiest balance sheets are in the emerging-markets economies. And even though PIMCO has taken down some of the risk in its portfolios over the last year than it had prior, it still has a healthy allocation to emerging-markets debt, and that is a sentiment that you see peppered into other portfolios across the category that you probably would not have expected to find a few years ago.

Benz: So, the thesis on emerging markets is what?

Jacobson: Again, it's really that that the fiscal health of these economies is so much stronger than the core G-7, G-20 countries and that they have fundamentally better balance sheets and a better ability to pay and so on and so forth. And the fact is as we know that historically they've paid a higher level of income than the kind of domestic-bond offerings and certainly Treasury bills and things like that that we have to choose from here inside the United States.

Benz: One other area, Eric that you noticed some of these active bond portfolio managers emphasizing is the nonagency mortgage-backed area. First, for the uninitiated, let's talk about what that sector is?

Jacobson: Sure. Well, the big agencies that people are probably familiar with are Fannie Mae, Freddie Mac and Ginnie Mae. Those are sort of the heart of the mortgage bond market. Nine out of 10 mortgages today that are initiated wind up getting guaranteed in some way or held by one of those agencies. Mostly, really at this point guaranteed and sold out in the marketplace. The "nonagency mortgages" are a big part of the market that still exists, but it's really a hangover from prior to the financial crisis. These are what we used to call private-label mortgages. These are mortgage pools that were packaged together by the various banks and then sold off as pieces and tranched, if you will, so that you'd have lower-quality pieces and higher-quality pieces. And after the financial crisis even the very, very high-quality pieces that were likely not really, if ever, to lose much money, if at all, became just killed by the financial crisis because all the underlying pieces below them disappeared, as money was defaulted out of the marketplace.

So, bottom line is what we're talking about here are mortgages that are not supported by any government agency. Most of them trade in relatively low-dollar prices compared with what we think of as agency mortgages. There are very, very high-quality pieces that have since bounced back and are either at/or close to par, but a lot of them are still cheap enough that managers find a lot of value in them, not only because they think that the market is still punishing them too much--and that's a big part of the thesis really, because there are only a limited number of managers who really have the analytical capabilities to buy them safely--but a lot of managers also own them because they feel that even at modest dollar price discounts, if there is an uptick in refinancing and people do wind paying off these mortgages, [the funds] get an extra kick from that kind of payoff. So, they get the advantage of buying them at prices that they think are really cheap. They get the higher level of income that that pays off at, and they get this possibility for a little kick from refinancing activity if it comes to pass.

Benz: So, if I crack open my bond fund's portfolio and see a heavy weighting in these nonagency mortgage-backed securities, should that make me nervous? What sort of weighting is within the realm of reasonable, and when should I start thinking, "Gosh, maybe this portfolio is taking a lot of risk?"

Jacobson: I think it really depends who your manager is because we don't see this as a perhaps widespread practice, but we see it among a handful of managers that we know have really strong resources for managing them. So, that would include TCW Total Return and Metropolitan West Total Return. DoubleLine is a very big one; that's Jeffrey Gundlach's. The big story for the last several years has been the way that he managed through the crisis and then purchased these things afterward. PIMCO Total Return even has a healthy, I think, roughly a 5% position there, if you don't include commercial mortgage-backed securities.

So, they are out there. If they are with those managers that I named, you probably either already know it or should be relatively confident that they have got the capabilities to manage them smartly. If it's a manager that you don't know that well, however, and it's farther down the list, you definitely want to try to understand why they are doing it or whether or not they really have the analytical heft to hang on to that stuff and make sure they know what they are buying and what they are holding.

Benz: Eric, last question for you. You've identified some of the areas that active managers seem to be overweighting of late, and I guess, the question is, should this foretell where the bond market is going? How good have active managers historically been at picking some of these spots?

Jacobson: Well, it's interesting. I think these things go in waves, where you have a really strong set of returns over a few years' time and then you wind up with a crisis. I think it's cliché. We've heard a few managers say things like this and there is some stuff in the press lately about where we are in the baseball game of the credit cycle, talking about being like, for example, in the sixth inning. I think maybe, I don't know if I said this earlier, but the fact is, we're probably not right around the corner from a wave of defaults or massive downgrades. There is some sense that the economy is actually doing reasonably well right now and picking up.

But as we get to this point where credit spreads are so tight, meaning prices are very high and yields are relatively low, we start to run into this place where the trade gets really, really crowded. And it's going to be the managers who decide to pull back that will be protecting their investors better than those who really want to hold on until the last little extra drop of income. Those folks [who stretch for that extra income] could wind up in trouble if we wind up with any particular market volatility.

Benz: Eric, thank you so much for sharing your insights. We always appreciate hearing from you.

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